Monday, March 14, 2011

Is risk risky if we can't see it?


We face many financial risks:  some more visible than others.  In this message we explain why it is important for investors to have a balanced perspective on the risks that they are taking.

Ten years ago everyone knew the stock market was 'risky' and residential real estate was a 'safe' investment. Back then, no one would have borrowed to buy stocks but people were using "no money down" loans to buy condos - it was a sure thing.

Well now we know it wasn't. It turns out that for many investors residential real estate was more risky than the stock market. So how did we get it so wrong? It may have something to do with the internet. Starting more than a decade ago, we began using on line tools to monitor our investment portfolios. Instead of getting a monthly statement or searching the stock listings in the back of the business section, we were able to instantly see our entire portfolio every day. And what we saw shocked us: stocks soared and then plunged with stomach churning frequency. If the swings weren't enough, we were assailed from every side by 24 hour financial channels, websites and radio shows shouting confusing and contradictory advice. Most of us hated this emotional roller coaster. By comparison, our homes seemed like such safe, sober investments. That's not to say their value didn't fluctuate - it did - it's just that without the instant reporting provided by the internet we couldn't see what was going on.

Experts call this the 'information risk premium'. Investments that are actively traded and reported on feel more risky because we see their daily fluctuations. By contrast, less visible assets like Hedge Funds or real estate may seem less risky simply because there is less daily attention placed on them. But visibility by itself doesn’t tell you anything about the relative riskiness of an investment. All things being equal, lots of market data combined with easy trading may turn out to be more risky if it causes you to deviate from your plan and turn fluctuations into real losses.

So what does this mean for you? First of all, relax - don't focus on day to day fluctuations - they are almost always meaningless in relation to your long term goals, second, spread your investments over multiple asset types, third, when evaluating the relative risk of a given investment, trust your plan, not your gut.

And remember: what matters is not the risk you see but the risk you take.

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